Detroit sues, challenging legality of massive pension debt deal

12:08 AM, February 1, 2014

Detroit secured a steady interest rate of 6% on the pension debt deal by purchasing 'swaps' now owned by UBS and Bank of America Merrill Lynch — but that bet soured when interest rates plummeted, sticking the city with a $50-million-a-year bill. / January photo by Eric Seals/Detroit Free Press

The City of Detroit filed a lawsuit Friday aimed at wiping out a massive debt from the Kwame Kilpatrick administration, saying that the now disgraced ex-mayor and city banks established 'a sham' legal structure that saddled Detroit with $1.4 billion in debt, which helped drive the city into bankruptcy. / 2010 photo by Mary Schroeder/Detroit Free Press

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The City of Detroit filed a lawsuit Friday aimed at wiping out a massive debt from the Kwame Kilpatrick administration, saying that the now disgraced ex-mayor and city banks established “a sham” legal structure that saddled Detroit with $1.4 billion in debt, which helped drive the city into bankruptcy.

The lawsuit, filed in U.S. Bankruptcy Court against two quasi-legal subsidiaries called “service corporations” and two trusts the city created, challenges a complex pension debt deal brokered in 2005 and 2006 that eliminated the city’s unfunded pension liabilities.

The city secured a steady interest rate of 6% on the deal by purchasing “swaps” now owned by UBS and Bank of America Merrill Lynch — but that bet soured when interest rates plummeted, sticking the city with a $50-million-a-year bill.

The city was also considering a lawsuit against Bank of America and UBS over the deal, with Detroit emergency manager Kevyn Orr giving the banks until 5 p.m. Friday to offer a settlement. The city is still in negotiations on that part of the deal, Orr spokesman Bill Nowling said.

The lawsuit challenging the legal structure of the so-called “pension obligation certificates of participation” deal marks a stunning admission that the city flouted Michigan laws by securing the debt to begin with.

Kilpatrick and his finance director at the time, Sean Werdlow, championed the debt deal as a brilliant way to reduce the city’s pension liabilities and prevent 2,000 layoffs in early 2005.

The deal was “illegal from the outset because it was a thinly disguised municipal bond issue using shell entities to exceed the city’s statutory debt limit,” the city said in a statement.

“This deal was bad for the city from its onset, despite reassurances it would adequately resolve the city’s pension issues,” Orr said. “We have tried, without success, to negotiate a resolution to this dispute and to allow the city and its taxpayers to move forward and unwind these illegal transactions.”

The lawsuit was filed in U.S. Bankruptcy Court’s Eastern District of Michigan against the service corporations and the trusts the city created to do the deal — and stuffed their boards with city appointees.

“There was no reason or purpose behind the convoluted structure of the ... deals ... other than to avoid the ... debt limit,” the city said in its lawsuit.

During a court proceeding earlier this month, Orr admitted that the city might be able to legally challenge the deal, arguing that it was a creative way to avoid the state’s ban on municipalities borrowing more than 10% of the assessed value of privately owned property within the city.

The lawsuit is likely to draw a fight from major bond insurers that backed the debt and pension certificate holders, made up mostly of European banks.

The lawsuit does not allege any corruption on the part of Kilpatrick or the partners in the deal. Kilpatrick is serving time in prison for corruption in other matters.

The suit comes one day after the Free Press reported some of the details of Orr’s proposed plan of adjustment, which creditors received Wednesday. The plan spells out how the city intends to satisfy creditors, bondholders and others as it goes through the largest municipal bankruptcy in U.S. history.

Bond insurers called Ambac Assurance, Syncora and Financial Guaranty Insurance Co. have vigorously contested the city at various stages in the bankruptcy.

“The deal was looked at rigorously by outside advisers on both sides and was a necessary step for the city at the time,” Spencer said in a statement.

But other major creditors — including unions and retirees — are likely to back the city in the lawsuit because they would receive more money if the debt is wiped out.

“We’re suing the shell corporations,” Nowling said. “We are going back and we’re saying the action the city took was illegal action. It did not have the legal authority to execute those contracts.”

The future of the swaps debt is also in jeopardy. Nowling said the city is still in negotiations with UBS and Bank of America over a potential settlement. The city previously said today was the deadline for a deal.

Meanwhile, the city has been unable to negotiate new terms with Barclays on a loan to borrow $120 million to improve city services, which must be reconfigured after Rhodes rejected a plan to use an additional $165 million in Barclays money to pay off the swaps.

The city is still negotiating the loan with Barclays, but if the deal collapses, the city would likely request loans from one of three other banks that sent commitment letters to the city when it was originally seeking borrowed cash to eliminate the swaps and improve services.

The original loan with Barclays had to be completed by Friday — and the city’s original settlement with the swaps banks also had to be executed this week.

But Rhodes has questioned the legality of the original swaps transactions, saying the city would “likely” win a lawsuit against UBS and Bank of America if it pursues the case. He also said there was a strong argument that the city skirted the state’s legal debt limit in the certificates of participation deal.